Why Quality Stocks Make Sense Now

The yield on the ten-year Treasury topped 5% last week for the first time since mid 2002. That says something about what happens next in the markets.

The Federal Reserve has steadily raised the Federal funds rate, from 1% in June 2004 to 4.75% today. The Fed is almost certain to raise the rate to 5% next month. After that, it's not clear what the Fed will do.

But although the Fed sets short-term rates, investors in the bond market control long-term rates. And long-term rates have remained stubbornly low in what former Fed chairman Alan Greenspan once called "a conundrum."

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Now the conundrum appears to be dissipating -- and not just because of rising rates in the U.S. Central bankers around the world, most notably in Japan, are raising rates, as signs of a stronger global economy emerge.

As long-term rates rise, the days of easy money -- of the globe being awash in cash looking for a home -- are drawing to a close, too. That global liquidity has inflated the prices of "junk" bonds, residential real estate, real estate investment trusts (REITs) and some mighty risky small-cap stocks.

My hunch is that the party is close to over. Logic argues that, with less global liquidity, money will head for safer securities -- whether that means government bonds rather than high-risk corporate bonds, or larger, more stable stocks rather than smaller, riskier ones.

Look at just how pricey small-cap stocks have become. The small-company Russell 2000 index currently trades at 29 times the past year's earnings. By comparison, the Russell 1000 index, which is oriented toward large-capitalization stocks, trades at just 19 times trailing earnings.

Why would investors pay such a huge premium to buy small-cap stocks, which by their very nature are riskier than larger ones? The answer, of course: because small caps have produced better returns.

But as small-cap managers close their funds to new investors one after another, it's clear to me there are precious few deals left among small-cap stocks. Meanwhile, the best large-cap managers I know say they are finding bargains everywhere among blue chips.

Don't turn your back on small caps altogether. No one knows for sure what will happen, nor when it will happen.

And not all "risky" stocks will do badly as global liquidity dries up a bit. Emerging-markets stocks have been on fire (the MSCI emerging markets index is up an annualized 30% the past three years). But earnings and revenues have risen almost as fast as stock prices, meaning stocks in developing markets still aren't overpriced.

What to buy? My favorite large-cap fund is T. Rowe Price Growth Stock (symbol PRGFX). But there's nothing wrong with an SP index fund such as Fidelity Spartan 500 Index (FSMKX) or ETF such as iShares SP 500 Index (IVV).

Mix in a great foreign fund like Dodge Cox International (DODFX) and a small position in an emerging-markets fund, such as SSGA Emerging Markets (SSEMX).

Finally, don't forget some low-risk, high-quality, intermediate-term municipal bonds. I'd pick either Fidelity Intermediate Municipal Income (FLTMX) or Vanguard Intermediate-Term Tax Exempt (VWITX).

Opinions expressed in this column are those of the author.